As markets fall, goodwill hard to maintain
David Parkinson. The Globe and Mail. Toronto, Ont: Mar 17, 2009. Pg B15
By late 2008, David Adams could tell with one glance at his books that the market had handed him a problem.
The chief financial officer at Groupe Aeroplan Inc. was carrying almost $3-billion in goodwill on the flight-reward company's balance sheet, most of it residue from its 2005 spinoff from ACE Aviation Holdings Inc. But the entire market capitalization of Aeroplan's stock, which had been close to $5-billion in early January, had tumbled to $1.3-billion by late November. According to the market, the entire company was worth less than half of the value of its goodwill ...view middle of the document...
, CanWest Global Communications Corp., Great-West Lifeco Inc. and Gerdau Ameristeel Corp.
Financial executives argue that the writedowns are non-cash charges that don't reflect on a company's operations. But analysts warn that the implications may be more severe.
By definition, a goodwill writedown reflects a permanent impairment in an asset's future cash flow potential, which could imply a risk to dividends. Analysts warn that the writedown of assets may put at risk debt covenants and hurt a company's ability to raise funds, and that it also amounts to an admission by management that it overpaid to acquire assets.
"I would argue that if you're holding the stock [of a company with high exposure to goodwill], you should be concerned about it," said Peter Gibson, vice-chairman and strategist at Desjardins.
While goodwill is a fuzzy concept, in strictly balance sheet terms it represents the gap between the fair value of an asset and the price its owner paid to acquire it. When a company acquires assets at a price above their fair value, the excess is recorded as goodwill - the implication being that the asset's prospects for future growth in cash generation justify the premium paid, and thus have value in themselves.
Goodwill writedowns typically accelerate during bear markets, as companies adjust their assessment of the cash-generating potential of assets purchased during better times to reflect the new, much less rose-coloured reality. But this time around, goodwill charges are headed for unprecedented heights, because regulators changed the rules governing the accounting for goodwill since the last bear market.
Before 2002, companies were required to amortize goodwill on their books annually, so it would eventually shrink to nothing over time. In 2002, U.S. and Canadian accounting regulators decided to allow companies to carry goodwill perpetually on their balance sheets, but required them to run an annual test to determine if there were any underlying change in valuations that had undermined those goodwill estimates, known as a goodwill impairment.
If warning indicators crop up in between annual impairment tests - such as a sharp drop in market value, or a serious deterioration in business conditions - regulators have directed companies to test immediately to see if a goodwill writedown is required.
During the downturn of 2001, before the rule change, goodwill writedowns in the U.S. totalled $51-billion (U.S.). That number has already been easily eclipsed in this recession: Two companies alone - Sprint Nextel Corp. and Courier Corp. - combined for $54-billion in goodwill writedowns.
"I'm not sure there is any historical precedent, " said Karen Parsons, an accountant and business adviser at consulting firm Grant Thornton LLP in Toronto. "This is really the first test."
Compounding the rule change is the fact that during the 2002-07 bull market, companies routinely paid big premiums for acquisitions. Now, many of the growth assumptions...